Greece versus China

Who would have thought that Greece was going to be more important for oil and copper prices than the middle east or China?

For much of the last year, commodity price movements have been tied to the so-called carry trade based on the inverse correlation between U.S. dollar denominated prices of commodities and the U.S. dollar exchange rate.

The accompanying charts (http://www.thebigpicture.com.au/atc/FX_commodities.pdf) show the relationship since the beginning of 2006 between copper prices and oil prices and the U.S. dollar trade weighted index, to illustrate the connection.

If anything, the trade had become progressively more overcrowded by institutions following the herd to tap what had seemed a near-certain outcome. Consequently, the recent strengthening in the U.S. dollar has begun to take its toll on the commodity prices most sensitive to the trade such as copper and oil.

Future weakness in the U.S. dollar has been a commonly held view based on worries about how large US budget deficits are going to be funded. For some, that has been one pillar supporting medium term commodity price strength.

Among the reasons exchange rate forecasting is always difficult is that a foreign exchange rate is not an absolute price. In a two currency world, both currencies cannot fall. The U.S. dollar and the Euro cannot both fall except against third currencies.

The risk of default by Greece, initially, and potentially Spain, Portugal, and, possibly Ireland and Italy has changed the expected trajectory of the U.S. dollar, at least against the Euro.

The unflatteringly described "PIGS" economies have raised the spectre of a second stage in the global credit crisis. The build-up in debt to cope with the effect of the first stage has begun to destabilize some of the more volatile economies. In Europe, these have included some that already suffered from a shortage of policymaking credibility.

The magnitude of the debt alone is not the problem. The contribution of Greece to the GDP of Europe is less than the contribution of California to the GDP of the USA. California's debt is larger as a proportion of its state output than the debt of Greece and it has a lower credit rating. The key difference is a flaw in the monetary system in which Greece operates. A secondary element is the weak credibility of the Greek government in economic management.

The Euro had always been on potentially shaky ground as long as individual national economies were able to run independent fiscal policies. They were nominally obliged to keep their budget deficits below 3% of GDP under the agreement admitting them to the monetary union but, once the limit had been breached, there were no formal steps to drag them back.

A bailout by the stronger economies such as Germany might be a stopgap but the Germans will surely fear a queue of supplicants forming in Berlin and a fresh burden on German taxpayers. A less direct rescue could involve the International Monetary Fund with the German government buying bonds issued by the Fund. Either way, there will be pressure on the survival of the monetary system.

Eventually, for this reason, the stronger European nations will probably have to subsidize the weaker ones, sapping the medium term economic strength of the whole European region as the cost of keeping it together.

Against this background, the Euro will become a less desirable place to park funds. The U.S. dollar will lose a potential competitor for the role of international reserve currency and may not depreciate against the Euro in the way that had been widely expected.

Once markets start to accommodate that possibility, the overcrowded carry trade could start to unravel quickly. The sell dollars/buy commodities strategy will have had its day with its greatest impact probably felt on oil and copper, where the trade was most pronounced.

Over the longer term, commodity price fundamentals will reassert themselves to become more prominent in the price setting process. In the shorter term, however, what happens in Greece (and its fellow PIGS) could well be the main driver of copper and oil prices.

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